Freemium Services and the Economics of Social Networking

Social networking sites face a unique economic challenge when it comes to monetizing the value they create. Most attempts to capture a piece of the value they create inevitably damages that value.

In a normal business, a company creates products that provide value and, as part of the transaction, capture some of that value in the product pricing. As long as the price is greater than the cost of producing the product and less than the value the product creates for the customer, the company will make money from selling the product.

Life isn't "this easy" for a business based on social networking because the value it is creating—unlike basically any other business—is based entirely on the number of people using that site. Increasing the cost of a social networking site to a member thus launches a cascading loop that reduces value of the system which causes a loss of subscribers which causes a loss in value (and on and on)...

Basic Economics and Reese's Law of Social Networking Monetization

Let's go back to high school economics for a few paragraphs.

First, the foundation of capitalist economics is the fact that we all place different values on different goods and services. I might think that a given product is worth $1.00. Absent the presence of substitute goods, I will therefore pay up to $0.99 for that product and be indifferent at $1.00. On the other hand, you might place a value of $2.00 on that product. As a result, you will buy that product at $1.01 and I won't.

In general, as you raise prices, demand for your product decreases—something called demand elasticity. The more a price change impacts the demand, the more elastic it is said to be. Some things like healthcare have almost no demand elasticity while other things like commodity goods in the grocery store are very elastic. For most kinds of products, the fact that I no longer want to buy a product due to a price increase has no significant bearing on the value another customer perceives in the good.

Other factors come into play, but complicate the picture unnecessarily for our purposes. Competition, for example, will change the value calculation. You may be willing to pay $2.00 for a widget, but if one vendor is charging $0.99 and the other is charging $1.01, you will always go to the vendor who sells it for $0.99 because that vendor is maximizing the end value of the transaction for you. Competition thus drives the cost of a product towards the cost of the good to product. In addition, things like the ability to create supply for a product as well as the cost to produce determine the ultimate price at which you will be profitable.

The curious feature of social networking is that the value any consumer of social networking systems realizes is tied to the number of people with whom the system enables them to interact. In other words, to maximize the value of your social networking site to your customers, it absolutely must be free to those subscribers from the start.

A inviolable law of social network monetization is thus:

The value of a social network service for any individual subscriber depends on the number over all subscribers and thus decreases as the cost to other subscribers for accessing that service increases.*

How to Monetize a Social Networking Service

If you elect to monetize your social networking site via subscriptions at some future point, you have to do one of two things:

Create a tiered offering through which services whose value is not directly tied to the population of the people paying for the tiered service.

Reach a level of price inelasticity that enables you to increase price without reducing demand.

LinkedIn is probably the best example of a company taking approach #1. The core social networking service is free. The value of their premium offerings, however, do not depend on how many other people are paying for their premium offerings. In other words, the premium member realizes the value of LinkedIn InMails regardless of whether any other LinkedIn user is a premium member.

Classmates.com, on the other hand, is likely the best example of how not to do handle premium offerings in a social networking environment. The "premium" services for which they charge money are tied to how many other people are willing to pay the premium to participate. Though they have a facade of "free" services, those free services are largely worthless no matter how large the network.

I honestly don't know of a good example of achieving high inelasticity in social networking. To achieve significant price inelasticity, you must develop a monopoly position in a product or service that is considered difficult to live without. The key to such a market position in social network would be the development of some kind of impossible to replicate intellectual property. That's not happening with any of the tools we know and use today.

Social networking sites have the capacity to create value for stakeholders other than subscribers. Anywhere you have a significant number of people "gathering" together for a purpose, you have potential advertising value. When you engage in advertising, you have to be careful to do so in a way that does not damage the subscriber value since damaging the subscriber value will cost subscribers and thus initiate the social network death spiral.

Poor Twitter

Twitter has a unique problem among social networking systems. They have built the size of their network around an open API that has enabled the growth a rich ecosystem of tools that combine with the source of the network to create its value. Without that ecosystem, Twitter is nothing. The user interface into Twitter is downright awful and the underlying architecture is famous for its weaknesses. This reliance on third-party tools makes premium services and non-subscriber services particularly difficult.

To charge for premium services, you have to have full control over all the data. Without full data control, any third-party can offer up similar "premium" services and give them away for free (say, Google). Twitter lacks control over its data except the potential at some future date to re-assert control over the data. While it's possible Twitter may one day leverage this power and assert control over its data to provide premium services, it's very uncertain how their ecosystem may react to such a development. If Twitter sufficiently damages its ecosystem, it will lose subscribers and thus diminish its value.

To advertise, you must control the delivery of your content. Twitter currently controls the display of its content only through the Twitter web UI. The ecosystem, again, has most of the control over content display. Consequently, Twitter must pull away display control from the third-parties that make their success possible. They can accomplish this feat in one of two ways:

Create a better, compelling UI with features unique to the Twitter UI that third parties cannot leverage.

Insert advertising into the Twitter stream and require third-parties to carry that content.

The former is unlikely as the Twitter team has shown a unique level of incompetence when it comes to web usability and design. The Twitter UI is not simply a basic, simple UI by a team who believes in leaving value-added services to third-parties—it's the primary barrier to adoption of Twitter among the general public.

The latter is the most promising, but it's unclear to what degree it can succeed. It certainly doesn't damage TweetDeck to carry an "advertweet" as part of the core stream, but there is also no compelling reason for it currently not to filter advertweets out of the user's tweet stream. Twitter would therefore have to compel TweetDeck and others not to filter out such tweets.

Whatever Twitter does, it's clear there is a coming clash between Twitter and their ecosystem in areas in which Twitter is horribly dependent on its ecosystem.

* Among interesting side effects is that I don't have to be the one being charged to access the service. If Twitter starts charging you to use Twitter, my value from Twitter gets diminished.